on the dollar-yen exchange rate

Link post

Recently, the yen-dollar exchange rate hit a 34-year low. Why is that?

6-month US Treasuries are paying around 5.3% interest. Japanese government bonds are paying about 0%. That being the case, you can borrow yen, trade it for dollars, buy US bonds, and get more interest. That’s called a “yen carry trade”. The risk you take in exchange for that money is that the exchange rate will shift so that a dollar is worth less yen.

But of course, it’s also possible that the exchange rate will shift in the other direction, and that’s what’s happened recently. From 2020 to now, $1 went from 105 to 150 yen.

That being the case, I’d normally expect inflation to be higher in Japan than the US—their currency became less valuable, which makes imports more expensive. Yet, that’s not what happened; inflation has been higher in the US. In Japan, you can get a good bowl of ramen for $6. In an American city, today, including tax and tip you’d probably pay more like $20 for something likely worse.

The PPP /​ nominal GDP of Japan is now ~1.5x that of the US, and I’d argue that’s actually an underestimate: PPP estimates don’t account for quality of services, and a lot of Japanese services are higher-quality than their US equivalents. But that’s not to say I envy how the economic situation of people in Japan has changed. While inflation was lower in Japan than America, wages barely increased, and real incomes of most Japanese fell.

In some countries, you can argue that crime or lack of property rights or inadequate infrastructure keep labor values down, but that’s not the case for Japan. So, we’re left with some questions.

Question 1: Why would an hour of labor from an American be worth 2x as much as an hour from a Japanese employee?

I remember talking to an economist about this once, and he said, “that means Japanese labor is just not as good as American labor”—but he was just wrong. (He didn’t even consider the possibility that Japanese management culture was the problem, because obviously inefficient companies would just get outcompeted.) There’s something about a lot of economists where, when they have some model and reality disagrees with them, they seem to think reality is wrong, and aren’t even inclined to investigate.

I’ll have to get back to this later.

Question 2: Why do Japanese automakers operate some factories in America instead of importing everything from Japan?

I can answer this one:

  • Direct labor is generally <20% of the cost of a car, and a lot of components can be imported from other countries.

  • Shipping a car to the US from Japan costs maybe $1000.

  • For US imports from Japan, there’s a 2.5% tariff on cars and 25% on trucks. Trucks make up the majority of Ford’s profits; they basically can’t make a profit when competing with Japan with no tariff.

  • Most of the US factories were built decades ago, and new factories are being made in Mexico instead.

Question 3: Why can the Japanese government keep borrowing money with no interest?

That debt is funded largely by bank deposits from Japanese citizens. I asked a Japanese guy I know why people don’t put their money in something that yields more interest, like US bonds, and he said:

Japanese people think of investments as having risk, and bank deposits as being safe. They don’t really understand that their bank deposits aren’t inherently safer than some other things.

Question 4: If dollars are overvalued, why does America have any exports?

A lot of US exports are currently oil and gas products, which are natural resources being used up. I personally think the US government should tax the extraction of natural resources, because they have some value that should be collectively owned by the population, but that’s another topic.

How about food exports? Some farm crops are subsidized, and the US has a lot of good farmland, but maybe the farmer subculture that the US has is particularly competent.

Boeing exports planes, but note:

  • Some components are imported, ~30% for the 787.

  • The manufacturing of Boeing planes is largely in lower-density areas with lower wages. Their factories and US suppliers have lower wages than the US average.

New drugs, movies, and software have low marginal costs relative to their development costs. It’s possible that development of them would be cheaper if it was moved to another country, but moving complex institutions to another country is difficult. Still, relying on institutional inertia isn’t a good long-term economic plan—these days, Yandex and Baidu can do search as well as Google, Genshin Impact makes as much money as the entirety of EA, Tencent owns Riot Games, American movies are losing popularity in China, and TSMC’s semiconductor production is ahead of Intel.

Question 5: If American labor is expensive, what’s it doing?

Rents are set by what people can pay. Wages are set by people’s other options. If paying Americans to work in factories or do welding or whatever is too expensive, what are Americans doing instead? The answer is “services”. But everyone working as DoorDash delivery and childcare for everyone else doesn’t work. Indeed, DoorDash workers don’t make enough to get their food from DoorDash, and cooks at restaurants don’t make enough to eat out at restaurants much.

Those services only make sense economically if they’re for richer people than the workers. The lower class cooks and delivers food for the middle class, which provides administration and luxury services, and at the top of a pyramid of services is wealthy people who own the factories that produce stuff and some of the houses that poorer people live in. NYC and London have high average incomes, but they don’t produce and export physical stuff; their main role is to provide luxury services to the people who provide luxury services to the wealthy people who own stuff elsewhere. In an egalitarian society, the same group of people both produces and uses goods, but the income and wealth inequality in America today has led to more stratification.

Question 6: Why do people want dollars if they’re overpriced?

One reason is to buy stocks. The US stock market has gone up a lot, while the Nikkei 225 and Shanghai Composite Index have been flat for decades, despite Chinese economic growth. Investors in public stock markets seem to capture more of the economic value of companies in America. And foreign ownership of US stocks has increased greatly over the past few decades.

Another reason is to buy Treasuries. At current rates, the short-term ones aren’t bad—I own some myself! In theory, the economic system is supposed to get people to put their money in whatever the best use for it is. Do I think whatever the US government does with my money is the most-productive use for it? No, at this point I think of Treasuries as more of a very slow Ponzi scheme, with plenty of bagholders (people with bank deposits getting invested in 20-year Treasuries) in front of me if things ever go bad. If a groups is continuously borrowing lots of money, it should be investing that money in productive assets to pay back those loans, but that’s not what I see happening.

Then there are the exports mentioned above, but imports are substantially greater—and if anything, US imports are underestimated, because of companies overvaluing final assembly of imported components in order to meet “made in the USA” labeling requirements.

Question 7: Is that actually a problem?

So, suppose the US totally deindustrializes, and can buy all its stuff from China, while putting all its efforts into a pyramid of luxury services, education, and medical treatment. Is that a problem? Well, when I put things in an exaggerated way like that, maybe it does sound like a problem. But what exactly are the issues?

  • The US is selling debt and assets over time, and that’s not sustainable forever.

  • Doing engineering produces knowledge externalities, more so than waiting tables or financial engineering. Engineers learn things from doing their jobs, and they sometimes switch companies, usually staying in the same country, so companies aren’t capturing as much value from local manufacturing as their host country is.

  • Goods and services that require expensive infrastructure or extensive training tend to have higher consumer surplus, because they’re less substitutable by the consumer’s labor. Cooking instead of going to a restaurant isn’t a big deal, but if you can’t buy computer parts, you won’t be making them yourself. This is true for companies as well as individuals, and the network of eg electronics suppliers in Shenzhen is important.

The last 2 points, while apparently too difficult for some economists to understand, can justify some tariffs or export subsidies, and governments seem to agree. But of course, government subsidies are decided politically. The best you can realistically hope for is a set of special interests that collectively push in mostly-positive directions.

Question 8: Why don’t Japanese invest domestically?

I already answered that, right? It’s because the Nikkei has been flat. But why is that?

An answer I’ve often seen is that Japanese stocks haven’t done well because the Japanese economy and population haven’t grown, but I don’t consider that a good answer. For one thing, the Shanghai Index also being flat indicates that other factors could be involved. But more importantly, companies have at least as many investment options as individuals: if people invest in Japanese corporations that can’t find domestic investments, those corporations could buy US stocks as well as their investors could. Banks own stocks, and Apple used to own $50 billion of Treasuries.

So, if returns on US stocks seemed better than investment inside Japan, companies could have bought those instead, and they should be about as informed as their investors, but companies also have extra investment options. For example, Japanese car companies could open factories in other countries—and they did!

The Nikkei 225 has given out dividends, so the flat price is slightly misleading, but they weren’t really higher than S&P 500 dividends. So that’s not a good explanation either.

One hypothesis is that Japanese companies just collectively failed to invest in projects with positive returns on average. They definitely invested in productive projects, so in that case there must be proportionate waste, but I don’t see that. Another hypothesis is that returns existed and were shifted somewhere, probably by self-dealing to privately owned companies. What would that look like, and why might it happen more in Japan than America?

Profit shifting from corporations isn’t a new concept; 150 years ago railroad companies were screwing over investors by hiring other firms controlled by management at inflated rates, famously including the Crédit Mobilier scandal. Such scandals led to more regulation of US corporations, but the oversight and transparency requirements for corporations in Japan are weaker. Of course, US corporations are still doing profit shifting on a massive scale, such as the Double Irish scheme where corporations pretend some IP was developed in Ireland and pay their Irish subsidiary for it, but it’s technically legal. I actually know an engineer involved in the Toshiba-Westinghouse Vogtle nuclear plant project who told me about how money was leaking and executives had to be involved.

Another difference between Japanese and US corporations is that US executives move between companies more. Japanese execs tend to stay in the same company and move up at the same rate, which gives more time for personal relationships and private deals to develop.

As for plausible total amounts of money, well, the Panama Papers covered $2 trillion of offshore transactions, which was largely legitimate activity but also only one law firm. The ICIJ estimates that the total global amount of money held offshore is between $5.6 trillion and $32 trillion. In China’s case, of course, returns would be siphoned mainly by the government instead. Money siphoned from corporations by self-dealing wouldn’t necessarily be offshore, but I think it mostly would be.

Japanese corporate financial scandals have been more about pretending a company had more money than it did, but that’s easier to find out than self-dealing, and that fraud still took a while to be exposed.

Jack Welch made money by cutting long-term investment in ways opaque to investors to make GE stock go up temporarily. With Japanese executives who have long tenures, good investments are still good investments; what I’d expect with self-dealing is increased debt rather than decreased investment. It’s true that Japanese companies have had a much higher debt-equity ratio than US ones. Large UK companies have had debt-equity ratios and stock returns between US stocks and Japanese stocks. Economically I’d expect companies to prefer to borrow more when stock returns are high, but across countries we’ve seen the opposite instead.

The US has about the same median wealth per adult as Japan and some European countries, but much higher average wealth, about 5x the US median. If, hypothetically speaking, those countries had a comparable Gini coefficient to the USA but the wealth was better hidden, their net wealth per capita would be similar to the USA. I don’t think that’s plausible, but it could be directionally correct.

Question 9: Why don’t foreign companies outcompete in Japan?

If big Japanese companies are all leaking money or all can’t invest well, either way, foreign companies should be able to outcompete them, right?

There are obvious language barriers and cultural differences, and that is a problem, but that didn’t prevent Japanese firms from opening factories in America and various other countries in the past. I think the main problem is the government making it hard for foreign firms to operate there, but if anything, it’s more fair to foreign firms than South Korea, which actually has a higher PPP GDP than Japan now.

Question 10: What could be done about these issues?

Regarding self-dealing in Japanese companies:

  • Disclosing the owners of private corporations is a start. Japan established new regulations about this in 2018 to meet FATF international agreements.

  • Random audits of payments from large corporations to private companies, weighted by payment sizes.

Regarding failure of companies to make investments with positive returns, that would mean the entire corporate system is a failure and a different way to choose company management would be needed.

Regarding failure of US companies to make long-term investments, the current “solution” is more private ownership of companies, and privately companies have had higher returns lately. The WSJ recently had an article saying “Private-sector investors are so ineffective at overseeing companies that state-run funds feel the need to step in”—so I guess that’s an option: governments could grant government-run investment groups the votes of index funds from that country. That’s not how things were originally meant to work, but neither is an aristocratic “board-member class” appointing itself to control of the economy.

Question 11: What if you’re an American who wants to make stuff?

I live in America, and my skills are largely related to design and production of physical stuff, so I’ve thought about this question a while, and I have a metaphor that I think clarifies the problem.

Imagine you live in a billionaire’s huge mansion, and you’re hired by the maids to fix their food. The billionaire in residence owns assets elsewhere, but is also mortgaging the building and furniture to pay for stuff. There are tailors who make clothes for people in the mansion, but the costs and prices of those clothes are higher than the clothes outside the mansion. A tailor says to you, “I’d like to try making some of the {thing} this house imports, but it’s expensive to do that here. What should I do?” The usual answer is, of course, to leave that house to make the {thing}. A 2nd option is to try to interest the billionaire in your project, and cater to their whims if they decide to make manufacturing {thing} a hobby of theirs. A 3rd option is to be so much better at making {thing} than people elsewhere that you can compete despite higher costs, perhaps by getting enough money from the billionaire to do things on a bigger scale, or perhaps by them using political influence to block competition. A 4th option is to act as a liason for the billionaire establishing production facilities outside the house.

If you’re not in a position to make such deals with the billionaire of the house, then your only option of those is the 1st one. But if you move to another country, apart from potentially bringing more money than most people have, or potentially having support (such as preferential hiring or investment) from other people from your original country, you’ll be at a disadvantage relative to native citizens.

Within a country, the above metaphor is more apt in some places than others. It’s more accurate in London or NYC than in a smaller town supported by a factory or mining. When companies do open factories in America, they try to do that in places unlike NYC: locations with a low cost of living where the factory can go right next to a highway. Within that metaphor, this could correspond to finding some remote corner of the mansion (relatively far away from the billionaire owner) to do your manufacturing in. Or maybe that would be outside the mansion but nearby? I’m not a metaphor specialist.

For a government that doesn’t like that dynamic, a possible response is to heavily tax luxuries (and perhaps types of administration/​lawyer/​etc spending that increase control but not societal wealth), use capital controls to prevent the wealthy from sending their money somewhere with lower taxes, and use that tax revenue to directly fund domestic investment. This isn’t a wild hypothetical: China’s government has a notoriously high luxury tax, strict capital controls, and directly funds domestic investment in manufacturing. (In 2010, luxury tax revenue supposedly funded 78% of the central government’s spending.) But in America, presumably, the government wouldn’t attempt such actions, and judges would block them if it did.